You are probably receiving countless calls and advertising mails each day pitching you the best investment strategies that have ever been created. Attached you will usually find a backtest with such stunning results that you are wondering why there is even a need to sell such a strategy.
After a long marketing call and some follow-up meetings, you decide to invest in the strategy but, alas, the day the product starts trading live, the performance tanks and so you keep losing money until you sell the product with a huge loss asking yourself how this could have happened.
The reason for this unpleasant experience is the egregious abuse of the research tool called “backtest”. In this Z22 Research Note we want to shed some light on why most backtests paint a wrong picture of reality and how you can spot erroneous results. You will also learn that the main reason why backtests enjoy such a bad reputation is not that asset managers are deliberately faking their results but simply the fact that they do not know how to use and interpret them properly. Even highly skilled scientists from different fields such as mathematics and statistics are often completely unaware of the unique pitfalls posed by dealing with financial time series.
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